June 2, 2002

Banks learn to look back in anger

Having believed all the new paradigm spin of the late 1990s, investment banks are now realising that there are no new paradigms and history repeats itself. The banks have acknowledged that a historian with a keen interest in past investment cycles, bubbles and historic boom/bust episodes could be of great value in predicting the fallout from the technology and telecom bubble of the past few years.

This will be of little comfort to Vodafone (formerly Eircom) shareholders, but at least it reveals an encouragingly sensible thought process in the investment community.

Two years ago this column argued that Eircom shareholders were not investors but speculators. This analysis was not based on any intrinsic knowledge of the telecoms sector; rather on a comparison with other boom/bust cycles in history — in particular, the 1840′s railway mania in England. History reveals that anyone who bets on a technology and expects stellar returns is a speculator not an investor. The telecoms boom and the earlier railway debacle mirrored each other in almost every way.

The international financial markets have suffered the boom/bust in telecoms and are now trying to deal with the legacy. The fallout is significant. There has been a huge drain on global resources as a result of the estimated $1,000 billion invested and lost in the late 1990s investment splurge.

The degree of suffering will be related to interest rates. If rates stay low, suffering will be bearable; if rates rise, the fallout will be significant. Since September 11, the emergency low levels of rates have given a false sense of security and inured the world against the full hangover of the 1990s profligacy.

However, there is no getting away from the fact that corporate earnings continue to underwhelm and no matter what the economists say about rosy futures, the corporate sums are not adding up.

Companies are not investing and balance sheets are weak. The booms of the past — whether the 1840s and ’50s railways boom in England or the roaring 1920s in the US — have been followed by long periods of under-investment and recession. If interest rates rise from here we may well get a repetition of this cycle.

So what is the long-term outlook for US interest rates? To answer this we have to look back at history. If the US is an empire — and many commentators say it is — the prognosis is not good because, over time, all great empires experience accelerating inflation, rising interest rates and a sharp depreciation of their currency.

In his book, History of Interest Rates, American economist Sydney Homer notes that interest rates have moved in “repetitious patterns” over the centuries. In addition, Homer observed that there was “a progressive decline in interest rates as the nations or cultures developed and throve, and then a sharp rise in rates as each ‘declined and fell’.”

US interest rates were in a long term declining trend between 1800 and the 1940s, when US long term government bond yields bottomed out below two per cent and have since then been rising irregularly. According to Homer’s interest rate calculations, we can conclude that the US Empire may already have passed its zenith.

In this respect, a quick analysis of the monetary history of the Roman Empire is helpful. Until the rule of Nero, the Romans only used pure gold and silver coins. But, having run out money, Nero proclaimed in AD 64, that henceforth the aureus would be ten per cent lighter. So, whereas in the past, 41 aurei had been minted from one pound of gold, from now on the ratio became 45 aurei to the pound of gold. Moreover, he minted a new silver coin, which was not only lighter in weight but also contained about ten per cent copper, which meant that the new denarius was worth about 25 per cent less than the old one.

Nero had set an important precedent and from the time he was deposed until the sacking of Rome (by Visigoths, Ostrogoths and Vandals) in the second half of the 5th century, a succession of emperors continued the practice of increasing the supply of money in the empire by debasing the denarius, which in the end only had a 0.02g silver content! The same is happening under Greenspan as US money supply is progressively expanded.

Back then, Roman demand for money was insatiable. It was plagued by endless problems including continuous border wars, internal discontent and strife, a heavy dependence on imported goods, a chronic trade deficit, slave rebellions, peasant uprisings in the provinces, power struggles between the rich eastern provinces and the poor ones in the west, plagues and poor leadership. And each time a new problem crept up, the money printing press was turned on which led to a further debasement of the currency and higher and higher inflation rates.

Similarly, the US prints money every time there is a problem and continues to run huge trade deficits with Asia and China.

We see similar developments in imperial Spain. Following Spain’s unification with Portugal in 1580, the 16th century Spanish Empire under Philip II encompassed by far the largest territory a sovereign state ever ruled. But prosperity was very short lived because all the gold and silver, which flowed in the 16th century to Spain from its mines in Mexico, was used for a series of costly wars. This led to very rapid price increases and also brought about a decay of agriculture and manufacturing on the Spanish Peninsula.

The Spanish Crown defaulted on its loans in 1557 and further defaults occurred in 1575, 1596, 1607, 1627, and 1647, leading to serious crises in major financial centres such as Antwerp, Genoa and Lyons, since they had been the prime financiers of the Spanish loans.

In many ways, the British Empire was the most successful empire in history because unlike the Roman and Spanish empires it did not depend on its colonies for its wealth but its manufacturing sector. In 1830, Lancashire had more machines installed than the rest of the world combined.

But over time the Empire also proved to be extremely costly to maintain and in the 20th century Britain had to give up its overseas possessions and lost out to other nations economically — a fact which was reflected in the British pound’s gradual depreciation against strong currencies. So, whereas in 1915, one pound Sterling bought 25 Swiss Francs, today it only buys about 2.5 Swiss Francs. British interest rates reached their all-time low near the Empire’s zenith in 1896, when yields fell to 2.21 per cent. Thereafter, yields never again reached these low levels — not even during the depression.

At the moment the dollar is beginning to fall, the US current account deficit widens by the day and interest rates are being kept artificially low. All this points to an erosion of imperial power, similar to developments in Rome, Spain and Britain.

This long-term upward movement of interest rates will ensure that the suffering associated with the great telecoms bonanza may be considerably more painful than commentators are now assuming. However, looking on the bright side, a history degree may well be worth a lot more in the future than it is today.